The Importance of Internal Control

April 23, 2010

You want to be an honest, accountable company. Why? For one, trust is a commodity that consumers value. Once you lose trust, it can take ages to regain it because people are suspicious by nature. You obviously want to build it up for as long as possible.

For another, companies have a great incentive to engage in dishonesty. The first Ponzi scheme originated in the 1800s and is still seen as a viable option for certain individuals. While you may not want to engage in heinous activities, you need to make sure that no one in your company can act in the dark.

What Are Internal Controls?

Internal controls are systems meant to monitor activity within a company, to ensure that the law is followed and that all processes are efficient. These audits measure risk and try to find potential weaknesses if a company is not doing well, as well as ethically dubious methods that should be abolished.

In short, internal controls also act as a unified failsafe. If someone is trying to cook accounting books or embezzle money, you want to have a system in place that catches them in the act or prevent it outright. They also will create a paper trail, ideally. If someone is less than ethical, you can measure how much went wrong and how to make amends.

Internal Control Objectives

Disclosure

You want to be transparent. Honesty is the best policy when talking about finances, especially with the public.

Validity

Your business processes have to make sense and have authorization. Make sure that you sanction everything that goes on with your company, in terms of the processes.

Rights And Obligations

Identify your assets and liabilities with honesty. This is as much for shareholders as much as it is for you. Shareholders are not happy if they find out a company has deceived them.

Completeness

Don’t half-baked your business activities. This should go without saying. Make sure every task is completed, or explain why you were unable to do so.

Valuation

In line with not cooking books, have legitimate systems for adding value to your products.

Case Study: Enron

Enron was one of the largest energy companies in California. They had a policy about building assets and then writing down projected profits as actual ones. Many power plants, as a result, ran at a loss, but the company managed to fool its investors. This went on for a while, and Enron hid all of its debt. The company also discreetly hid its conflict of interest with special-purpose vehicles — smaller entities that would take stock in a failing Enron asset and in turn would receive financial guarantees. By 2001, Enron would have to declare bankruptcy.

No one at Enron stopped to think, “Hey, maybe we shouldn’t be scamming millions of our customers or investors.” There were no systems to prevent the off-the-books accounting that hid the vast amount of debt. Their main accountant, Arthur Andersen, looked the other way when managing the company’s books. He was the first control that failed.

Unsurprisingly, when the law found out, it convicted all the involved parties — Andersen, CFO Andrew Fastow, and CEO Jeff Skilling. Later, the Sarbanes-Oxley Act was passed, by which businesses would face severe financial consequences if they deceived shareholders or falsified important documents.

How Internal Controls Help A Company

The importance of credibility in a company is priority number one. Internal controls exist to ensure reliable financial reporting, effective and efficient operations, and compliance with applicable laws and regulations. Imagine another Enron? The importance of internal control cannot be stressed enough.

They Prevent Fraud

It plays an important role in preventing fraud, detecting fraud, and protecting tangible and intangible assets/resources. One of the main things to keep in mind when establishing internal controls is to establish segregation of duties. Having more than one person complete a task gives you, the business owner, assured credibility that the task was completed right. Sometimes thought of as costly, the segregation of duties is very important in creating a system of checks and balances that maintain the credibility of employee job tasks. Picture an employee that handles all of AR and AP, the possibility of fraud grows as the segregation of duties is less divided among employees.

You Will Gain Systematic Freedom

Under the Sarbanes-Oxley Act, many of the previous known accounting processes and controls have been changed and regulated. The importance of internal control goes beyond preventing risks. The same internal controls can also be used to systematically improve businesses, particularly in regard to effectiveness and efficiency; starting by maintaining the segregation of duties. Why wouldn’t a company want to improve business processes, policy, and the internal environment?

Learn More From DeepSky

Are you curious about what you can learn about internal controls? Our team at DeepSky can assist in educating you on how to install internal controls for your business. With the right accountability, your customers will know to trust you for the long haul.

Contact us today to find out more.

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